The extent to which a firm is exposed or vulnerable to fluctuations in exchange rate is referred to as the exchange rate exposure and can be perceived in three different ways:
This defines the foreign exchange rate risk in terms of the impact of exchange rate movement on the firm’s future cash flows. This type of exposure arises from an obligation to either accept or deliver foreign currency at a future date. The most important transactions leading to transaction exposure are accounts receivable and accounts payables denominated in foreign currency.
Translation exposure defines exchange rate risk in terms of the impact of exchange rate movement on the financial statement of the firm. When a business is organized as several separate corporations, then financial statements must be filed on a consolidated basis so as to give shareholders concise and complete information as to the financial position and the operating performance of the firm as a whole. When subsidiary operate in a foreign country then major complications occur in consolidation process. This problem arises from the fact that financial statements of the foreign subsidiary are usually in a currency which is different form that of the parent company. The foreign currency must be converted into the home currency before accounts can be consolidated. Translation exposure therefore is the extent to which multinational firms consolidated financial statements are affected by the need to convert its foreign subsidiary accounts to the home currency. As the value of the exchange rate fluctuates, so would be the value of the foreign subsidiary.
Economic exposure defines exchange rate risk as the total impact on all the cash flow of the firm (both contractual and non-contractual) It is broader than the other types of exposure and may be considered to be the overall impact of the foreign exchange fluctuations on the shareholders wealth. It affects both the companies that enter into foreign currency transactions and those that do not.